Today, more workers are being asked to participate in and contribute to their own retirement plans. While Social Security is a valuable resource, we are wise not to rely on Social Security benefits alone for income during retirement. It is never too soon to start planning for retirement and it is the small decisions you make today that can have a big impact on your future. While you may already be saving in an employer-sponsored plan – such as a 401k – an Individual Retirement Account (IRA) allows you to save additionally for your retirement. And, you may also save on your taxes. There are different types of IRA’s with different rules and benefits. With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals after age 59½. With a Traditional IRA, you contribute pre- or after-tax dollars, your money grows tax-deferred, and withdrawals are taxed as current, ordinary income after age 59½. In this month’s Investor’s Edge column, I hope to highlight how these two vary and to help you determine which option is best for you.
A common question is, “Should I save for my retirement in an IRA or 401k?” The answer is one of affordability. If you can afford to, the answer is BOTH.
A Roth IRA and Traditional IRA are both good retirement accounts to consider. However, there are several key differences to keep in mind when determining which account is the best for you. Understanding the types of IRA’s available to you is an important step towards successful retirement planning. Understanding the differences between a Roth IRA and Traditional IRA will help you maximize your retirement savings. Let’s view the two side-by-side for comparison from 4 key considerations: Contributions, Taxes, Withdrawals and Penalties.
| ROTH IRA | TRADITIONAL IRA | |
| Contributions: | Contributions are made with “after-tax dollars”. | Contributions may be made with “pre-tax dollars” (more on this below regarding taxes). |
| Taxes: *on contributions *on withdrawals | Contributions are not deductible. Your contributions are withdrawn anytime without taxes. | You may be eligible to deduct all or a portion of your contributions. Deductibility depends on your income, filing status, whether you and/or your spouse are covered by a retirement plan at work, and whether you receive social security benefits. Withdraw anytime, but deductible contributions are taxable. |
| Withdrawals: Penalties: | A qualified distribution is tax-free if taken at least 5 years after the year of your first Roth contribution and you’ve reached age 59½ (there are some exceptions). No penalties on withdrawals. | Taxable when withdrawn (there are some exceptions). Withdrawals are generally subject to penalties if withdrawn before age 59½ (there are some exceptions). |
If you’re eligible to make a deductible contribution to a traditional IRA, consider putting as much as the $6,000 limit there—especially if you expect to be in the same or lower income tax bracket in retirement when you take withdrawals. If you’re age 50 or older, you can save up to $7,000 in 2019 thanks to catch-up contributions. As said above, the tax deductibility of contributions will be subject to income limits. If neither you nor your spouse (if any) is a participant in a workplace plan, then your Traditional IRA contribution is always tax deductible, regardless of your income.
If you’re not eligible to make a deductible contribution to a traditional IRA but you’re eligible for a Roth IRA, consider putting your $6,000 into a Roth (or $7,000 including a catch-up contribution). Contributions are made with after-tax dollars, meaning there’s no potential tax deduction in the year of the contribution, but qualified withdrawals are tax-free in retirement so long as you’ve held the account for at least five years and you’re over age 59½.
A number of things have to be weighed to know whether a Roth IRA is your best option. If you expect you might be in a higher tax bracket when you make your withdrawals, the Roth may be especially attractive. Ending up in the same bracket would mean a wash for income tax purposes—but a Roth IRA still has other advantages, including no tax on your accumulated investment earnings. It’s difficult to know what your future tax bracket will be in retirement. Consider, though, with current income tax rates historically low, they could rise in the future.
Also, a Roth IRA doesn’t force you to take annual required minimum distributions (RMDs) starting at age 70½, as you have to do with a 401(k) plan or traditional IRA. That’s an advantage in terms of letting your Roth IRA continue to grow tax-free in later years. It could also benefit your heirs, who’d be able take money out income tax-free at your demise.
Determining whether a Roth or Traditional IRA is best for you is worth doing. Like most things worth doing, it may not be easy. I hope this helped. If you have any questions, give a call at 888-985-PLAN.
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